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Capturing Systematic Risk Premia

Discussion NOTE 8 - 30 March 2012

This note illustrates the empirical risk/return characteristics of the different risk premia, and how one can design scalable investment strategies to capture systematic risk premia.

Main findings

  •  A huge academic literature documents that exposure to systematic risk in the equity market increases the return relative to a market-capitalisation-weighted index. Our research documents that several risk premia represent attractive sources of additional returns also for a large investor requiring high investment capacity. However, capturing systematic risk premia entails risk. We argue that a fund with the Government Pension Fund Global’s defining characteristics has a comparative advantage in taking those risks.

  • Strategies for capturing systematic risk premia can be constructed in a number of different ways. We illustrate how different methodological approaches impact the risk and return related to the capture of different systematic risk premia, and show that there are significant differences across methodologies, regions, market segments and time. Efficient capture of systematic risk premia requires carefully designed investment strategies that are customised to each risk premium.

  • We focus on five well-documented systematic risk premia, and illustrate how these risk premia may be captured by an investor requiring high investment capacity. The size of the different risk premia is significant even when we focus on the most liquid market segments. Each risk premium has, however, a substantial negative tail, and the success of a premium-harvesting strategy depends on the investor’s ability to sit through periods of underperformance.

  • The illiquidity premium is one of the risk premia that are suitable for a large investor with a long investment horizon to capture. Due to the challenges related to defining and isolating this premium, we suggest that this premium should be captured indirectly through other risk premia such as size, value and volatility.

  • The correlation between the different risk premia and their correlation with the market are generally low. Hence, the diversification benefits from approaching the risk premia within a unified framework are substantial. We show that a combined capture of a wide set of risk premia not only leads to lower volatility, but more importantly also to significantly reduced tail risk. 

  • Each risk premium has indirect exposures to other sources of systematic risk. Moreover, these indirect risk exposures vary over time. A strategy seeking to capture systematic risk premia therefore needs to actively manage both direct and indirect risk exposures, possibly also taking systematic risk exposures emanating from other parts of the Fund into account. As a result, the capturing of systematic risk premia should be implemented as a part of the overall risk allocation process within the Fund rather than through a passive tilt in the benchmark.

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